When borrowing money, it’s important to know all the options available to you, especially if you have specific plans for how and when those funds will be used.
For example: If you need a lump sum of money right away, a personal loan might be best. If you need access to credit over a period of time, a line of credit could be a better choice. And while there are some similarities between the two, it’s their differences that can help you decide.
Here’s some information to help you choose:
How does a personal loan work?
A personal loan is a specific amount of money lent to you in one lump sum. Once your application is approved, funds are typically delivered via check or a direct deposit that you receive at the time of your loan closing. Personal loans can be secured or unsecured and the terms can vary in length (24 months, 60 months, etc.).
As for repayment, most personal loans are considered installment loans since you pay the loan back in equal amounts each month. Personal loans also usually have a fixed interest rate, which means the monthly payment will stay the same if your account is up to date.
How does a line of credit work?
A line of credit is similar to a credit card. Instead of receiving all your money at one time, you get access to a set amount of money that you can borrow from when needed. The funds can be accessible through a special card or checks. Some lenders might also allow you to transfer funds directly to your checking account. After you qualify, the lender will likely designate a period of time when you can draw money from the account, or a “draw period.” This can last several years.
Minimum monthly payments will be due during the draw period, and you’ll pay interest on the amount that is borrowed. Since this type of credit is revolving, not fixed, the minimum payment can fluctuate with the interest rate and how much you spend. If you continue to draw small amounts over time, or a large amount in one transaction, the minimum payment could get higher. Once the draw period ends, you’ll enter a “repayment period” where you have a set amount of time to pay off any remaining balance.
Which suits you best?
Here are three things to consider when choosing between a personal loan or a line of credit:
1. Primary need for funding
Personal loans — These funds are typically used for one-time purchases and situations when you know how much money you’ll need. Common uses include debt consolidation, medical bills, auto repair bills and home improvement projects.
Lines of credit — These can be ideal if you need access to money over time or when you’re unsure of exactly how much you need to borrow. For example, if you need an open line of credit due to inconsistent pay cycles or you’re trying to get a small business off the ground.1
2. Availability of funds
Personal loans – Most personal loans are paid out in a lump sum and delivered via paper check or direct deposit to a bank account. But unlike lines of credit, you won’t have access to more funds once the loan is disbursed.
Lines of credit – Once the line is open, you should be able to request any amount you need that remains in your available balance.
3. Repayment
Personal loans – Most personal loans have fixed interest rates and fixed monthly payment amounts, if you pay on time. The predictability of the same payment amount can make it easier to manage a monthly budget.
Lines of credit – When repaying a line of credit, you're better off if you can pay your outstanding balance in full and on time each month. Personal lines of credit are usually subject to compound interest, which can add up quickly. This means that your minimum monthly payment is calculated by adding your previous unpaid balance + interest on that balance + any new charges. Also, the interest rate can change based on your credit score and other factors.
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The choice is yours
In the world of borrowing money, there is no “one solution fits all.” The right choice depends on your financial needs, your credit score and many other factors. As you narrow down your options, consider how each one will affect your finances and choose what’s best for you.
1. Pritchard, Justin. “Expected Rates for a Business Line of Credit.” TheBalance.com. https://www.thebalance.com/rates-on-a-business-line-of-credit-4153312 (accessed July 15, 2019).
